When the stock market goes in the tank, people that have invested in bonds breath a sigh of relief. And that is good. But there is some risk here as well, some major risk in some parts of the bond market.
Bonds carry three kinds of risk. The first is interest rate risk. When you buy a bond you are buying an interest rate. Let’s say 5% on a five-year $1,000 bond. If you are happy with 5% and hold the bond for five years you get your interest and your principal back. But maybe you need the money for some reason and you have to sell the bond before the end of five years. And let’s suppose that interest rates on five-year bonds are now 8%. The bottom line is that you can’t sell your $1,000 bond for $1,000. The buyer will discount your bond to get his yield up to at least 8%. A bit complicated but think about it—it makes sense.
The second risk is inflation risk. If inflation is greater than your interest rate you are losing money. Let's assume some hypothetical interest rates and inflation rates. Assume the current yield on a short-term corporate bond fund is 4%. Assume the annualized inflation rate ss 5%. A lot of that is gas prices but hey, you buy gas so your inflation rate is 5%. And your bond yield is 4% so you are under water. And you pay taxes on your 4%. Inflation is always after tax.
The third and greatest risk is credit risk. Who is issuing the bonds and are you going to get your money and interest back? This is where bonds are definitely not boring. The current issue of Forbes magazine looked at a couple of bond funds that haven’t done so well recently. One fund is the Morgan Keegan Select Intermediate Short Term Bond Fund. In 2006 the share price was $9.60. Today the share price is $.97. Let’s repeat that—the share price is now $.97. Put another way a 2006 investment of $1,000 is now worth $101. Ouch. What did Morgan Keegan invest in? You guessed it—collateralized mortgage obligation bonds.
Surely, they had to tell the investor what they were investing in. The truth is that they did. The problem is the answer was buried in a prospectus that runs tens, if not hundreds, of pages causing eyeballs to glaze over after the first paragraph.
How can you avoid problems if you want to invest in bonds? Easy. Just remember that if it looks too good to be true, it probably is. If someone pitches you a bond compare the rate with alternative bonds. If a Treasury bond is yielding 4% and somebody is offering you something at 8% check out their credit worthiness. The finance answer is always simple—the higher the risk, the higher the return.
If you want to do bonds, go for quality. Any banker or reputable, key word here is reputable, financial planner will explain to you the quality of one bond over another.
Or stick with CD’s if you are really conservative. You may not like the low rate but at least you will get your money back